A new surge in U.S. healthcare costs could position core inflation for its highest year-over-year gain since 2008. Chief Cross-Asset Strategist Andrew Sheets details what this could mean for markets.

Tighter monetary policy has led to greater volatility this year; from the Volatility Index (VIX) unwind in February, to emerging markets weakness in April, to the wobble in Italian bonds stemming from recent political uncertainty in the country.

Our core Personal Consumption Expenditures forecast of 2.2% for 2019 would make that the highest year-over-year gain since 2008.

But something is different this time. For much of the last nine years, easy policy was accompanied by low inflation, which gave central banks a great deal of room to maneuver. However, the inflation picture is now changing. Thanks to rising oil prices, headline inflation is now 1.9%Y in the eurozone and 2.5%Y in the U.S.

But this isn’t just about the effects of oil prices, which are arguably transitory. Core inflation is rising too. And for the most important inflation measure—U.S. Core Personal Consumption Expenditures (PCE)—for the most watched central bank (the Fed), there is a major change afoot that could keep core inflation higher, and push U.S. core PCE to 2.2% 4Q/4Q in 2019.

The Return of a Key Inflation Driver

For over nine years the accommodative policy of the Fed has supported markets and depressed volatility. That support was possible, in part, because U.S. core inflation remained low even as markets healed and growth recovered. And core inflation remained low, in part, because of the healthcare sector. Healthcare services represent about one-fifth of core PCE in the U.S., and the growth in its costs has been low since the passage of the Affordable Care Act (ACA). That’s helped to depress the overall level of core PCE, which in turn has provided significant leeway to the Fed.

But this trend in healthcare spending is now changing, per a fascinating note published last week from my U.S. colleagues in Morgan Stanley Research. The shift is stark.

After growing at roughly 3%Y per annum from 2002-08, healthcare inflation averaged just 1%Y from 2011-16. But it’s now rising, as provisions of the existing law shift as planned, and others are affected by actions of the current U.S. administration. Elimination of the individual mandate and the defunding of the ACA’s cost-sharing reductions, for example, will mean both fewer Americans with health insurance and an increased burden of uncompensated care on hospitals (an inflationary cost).

My colleagues estimate that healthcare inflation could be 2.6% 4Q/4Q by the end of 2019, and persist at that rate (or higher) for years to come. The Centers for Medicare and Medicaid Services estimate similar effects.

The result would be an additional 0.25 percentage points (pp) for core PCE versus recent years from healthcare alone. That may not seem like much, but core PCE has spent most of the last 22 years in a 90 basis point (bp) range between 1.2%Y and 2.1%Y. Our core PCE forecast of 2.2% 4Q/4Q in 2019 would make that the highest year-over-year gain since 2008.

Global Inflation Warms Up

I think healthcare is the most interesting part of this higher U.S. inflation story is because it’s a large sector, it affects core measures and is undergoing major change.

But a higher inflation narrative is decidedly global. In the eurozone, it’s being supported by a weak Euro, strong energy prices and steady readings from services. In the UK it looks increasingly homegrown as Brexit tightens the UK labor market further.

In China, producer price index (PPI) inflation is firmly above the 20-year average. And in Japan, our economists believe that a trend of rising inflation since late 2016 is firmly intact, supported by the lowest unemployment rate since 1993.

Reacting to Change

What does this mean for markets? While the level of inflation isn’t problematic in any of the countries above, we think that the focus this year will be on the rate of change. Coupled with decelerating G4+China growth and tightening G4+China policy, rising inflation should continue to drive a “tricky handoff” for risk assets and support lower, more neutral risk positioning. Rising inflation also makes it more difficult for central banks to support markets by easing policy, a factor that we think will drive higher realized volatility.

This thinking drives several views. First, that higher realized volatility is reducing the cost of owning volatility. We see possible opportunities across a wide range of asset classes, such as Japanese equities, G3 FX, long-dated Brent, U.S. high yield credit and U.S. 10-year rates.

Second, a pick-up in inflation does not necessarily mean one should buy breakevens. Our U.S. inflation strategist Guneet Dhingra has commented that inflation risk premiums in the U.S. are already quite high. Investors could look at EUR breakevens or long-dated (2020) Brent futures, which remains well below the forecasts of our Global Oil Strategist Martijn Rats and our energy team.

Third, this “tricky handoff” has created a market where diversification is both in demand but hard to come by. Recent work by our U.S. equity strategists suggests that what qualifies as a defensive sector in this cycle may look different than in the past.

Fourth, we think that higher core PCE will keep the Fed hiking, even as the market becomes skeptical about the economy’s ability to weather that tighter policy. This, along with higher front-end supply, drives our rates strategists’ view of a flatter U.S. curve, specifically in 2s7s and 2s30s.

As for Italy, the situation remains fluid, with large swings complicating any attempt to be strategic in what is still the third-largest sovereign bond issuer in the world. For now, our economists will be watching the composition of any new government, their proposals, and what this will mean for the country’s fiscal trajectory.